Q: How did all this start?
the 1980s and 1990s, beginning with the Reagan era, Congress has
engaged an orgy of deregulation, doing away
with the Depression-era safeguards that forced transparency and limits on US banking and financial companies. Regulations were repealed one-by-one; for example, in 1999 Congress passed a bill that repealed the Glass-Steagall Act and allowed commercial banks and investment banks to buy each other and combine operations under one roof. This era of massive deregulation also sparked the invention of creative and unusual investments, including derivatives, that were previously prohibited under earlier securities law.
So, before 1999, the financial industry consisted of commercial banks (with brick-and-mortar branches where you could deposit your paycheck and open a savings or checking account), investment banks and brokerage firms, mortgage companies, credit card issuers, insurance companies, etc., and they were all separate companies. After 1999, the gloves came off, and any of these companies could buy any other company, which caused a huge expansion in both the size and the profitability of US financial firms.
Moreover, any company could now issue loans. General Motors, for example, could now open a finance unit that issued auto loans, and they did. Customers wanting to buy a car didn't have to go to their banks to get an auto loans; they could finance the purchase through the company where they bought their car. This, of course, proved to be very convenient for US businesses, and very profitable.
Unfortunately, because of lax oversight and because of the explosion in the number of companies that were now issuing credit, it became impossible to track how much money was being loaned to whom under what terms, and whether businesses had the cash on hand to cover any shortfalls if a lot of customers defaulted on their loans. Nowhere was this more of a problem than in the housing market.
Q: I've heard about the problems with mortgage-backed securities, but I don't understand how that could cause such a huge mess. What happened?
A: To understand
the current crisis, you need to understand only one thing: what
mortgage-backed securities really are. Starting in 2003, banks
with mortgage units made a lot of risky mortgage loans. The banks
then bundled these loans together and called them an "asset"
(a mortgage-backed security). They sold some of these "assets"
to investors and used the rest as collateral to borrow more money
from other banks. Then they used that borrowed money to make more
risky loans, which they called "assets" and
used as collateral to borrow more money to make more loans, etc., etc. And banks did this in volumes that were so huge that it dwarfed the amount of cash and real assets that these banks owned.
So now our financial
industry is struggling under layers and layers of bad debt. Risky
subprime loans started going bad in 2006, but the first big wave
hit the financial industry in August 2007, when banks finally
had to own up to the problem and declare huge write-downs in the
value of their mortgage-backed "assets." This made their
stock prices fall, which effected the value of their companies
and made it harder for banks to borrow the cash they needed to
cover their bad debts. It's been a downward spiral ever
Q: Why is the collapse happening now? Why didn't it all happen in August 2007?
A: Because in
August 2007, nobody knew how bad the problem was or how long it
would take all the bad loans to come due. In fact, today we still
don't know the depth of the problem. Investors, the public, regulators,
the Fed, even the CEOs at the banks involved in this whole Ponzi
scheme still can't come up with a figure for exactly how many
bad loans are out there. It's been a year--a psychologically important
timeframe on Wall Street--and banks are still taking write-downs
and scrambling to borrow more cash to
cover their bad debts.
The fact that nobody knows the size of this problem is key to understanding the current panic. Without information, everyone is free to image a doomsday scenario. And they may be right, we just don't know.
As an example of how clueless everyone is, we need only look to the Fed chief, Ben Bernanke, and Treasury Secretary Henry Paulson. Bernanke and Paulson will be presenting an industry-wide bailout plan to Congress in the coming days that's estimated to have a price tag of $500 billion. But where does that figure come from? Keep in mind that Bernanke and Paulson have avoided putting a dollar amount on the bailout plan themselves; members of Congress are the ones who came up with the $500 billion figure. Nobody has explained the basis for it, but my guess is that they took the IMF's estimate of the crisis ($1 trillion) and subtracted the amount that the Fed and the Treasury have already poured into the financial markets (about $500 billion) and came up with the difference. So $500 billion is just a guess, a number pulled out of hat. The total could be much higher. Or it could be lower, but I wouldn't count on that.
Q: Explain more about the government bailout. Why did the Fed bail out AIG and not Lehman Brothers?
A: Lehman was hovering on the verge of bankruptcy a couple of weeks ago, but they had the opportunity to work out a sale to a group of investors. The investors, however, didn't offer Lehman enough money, and the CEO of Lehman turned down the deal. He was hoping to get a better deal from the Fed, similar to the bailout of Bear Stearns. But the Fed turned him down flat. When that happened, Lehman's stock price plunged drastically, and the investors who'd offered to buy the company said, "no way, this isn't a good bargain for us anymore," and took the deal off the table. Lehman was forced to declare bankruptcy.
Merrill Lynch, on the other hand, could see the writing on the wall. Instead of holding out for help from the Fed, Merrill agreed to be bought out by Bank of America for about 50 cents on the dollar.
Within hours of
the Lehman collapse, the insurance industry behemoth AIG was driven
to the wall. Because AIG owes hundreds of billions of dollars
(no one is sure yet exactly how much they owe, but it's a lot)
to foreign banks and foreign governments, the Fed simply couldn't
let them fail. To do so would be a global economic disaster. It
would also have serious political repercussions and shake global
confidence in the US financial system. So a bailout was necessary
to prevent a run on US banks, a huge sell-off of US corporate
stocks, and--this is the real nightmare scenario--a massive sell-off
of US government treasuries, which are owned by most foreign banks
and governments around the world. If the US government loses the
ability to borrow money cheaply through sales of
treasury bills and bonds, then it becomes impossible to come up with the cash to pay the interest on the federal deficit and pay for the war in Iraq, much less find the money to bail out anyone.
Q: So how did AIG get into this mess? Isn't AIG an insurance company, not a mortgage lender?
A: That's right. AIG didn't issue mortgages or mortgage-backed securities; instead, they sold massive quantities of a derivative called a "credit default swap." Essentially, that's a form of insurance that hedges against mortgage-backed securities.
Here's how it works. If an investor owns a lot of mortgage-backed securities, they might want to protect themselves against a fall in the value of their investment. So they might buy insurance that would protect them against the loss in value of their mortgage-backed securities. That's what credit default swaps are. By buying credit default swaps, the investor would be "hedging" their investment.
AIG sold some of these derivatives to US banks and investors, but they sold most of them to foreign banks and foreign governments, because foreign markets operate under different rules. Many foreign governments have regulations requiring their banks to limit risk or hedge their riskier investments. When the market in mortgage-backed securities tanked, AIG's customers came knocking, looking for payouts on their credit default swaps. AIG was able to cover the payouts for a while--for more than a year, in fact. But shareholders looked at AIG's business and got nervous about AIG's ability to keep paying. AIG's stock took a pounding, the value of the company fell, and suddenly they couldn't borrow enough cash to cover all their debt payments. They simply ran out of cash.
Q: Just a second...define "derivatives" for me. Just what the heck are they?
A: Defining "derivatives"
is almost impossible, since the term encompasses so many different
types of investments (which is why you can search high and low
for a definition and not find a satisfactory one). Maybe the
best definition would be: "a catch-all term to describe non-traditional
types of investments. Derivatives can be any immaterial thing
that people are willing to pay money for." An example of
a derivative might be a piece of paper representing the likelihood
of an event that may or may not occur in the future. As long
as people are willing to buy and sell that piece of paper (make
a market in it), then that derivative has a value. When people
lose interest in buying that piece of paper, the market for that derivative collapses and the investment is deemed worthless.
It's important to note that mortgage-backed securities are not derivatives--they're bonds made up of individual mortgages bundled together and sold as a package. Unfortunately, when investment banks put together these mortgage-backed bonds, they grouped good mortgages with lots of really bad subprime mortgages and "liar loans" (mortgages issued to people who didn't have to show any proof of their income or assets). Investment banks, along with the major ratings agencies (Moody's, S&P, and Fitch), colluded to market and sell these bonds as extremely safe investments, when in fact they were extremely risky investments. So when a lot of subprime mortgages began to fall into arrears in 2006, it took a while for that to impact the value of mortgage-backed securities, but the collapse of the mortgage-backed securities market was inevitable. It proves that, while derivatives are extremely risky investments, high-risk securities can be created anywhere in a system with little or no regulation.
Q: They keep telling us that taxpayers own AIG now, but isn't the Fed a private bank? Who really owns AIG and what's it worth?
A: Yes, the Federal Reserve Bank of New York is a private bank. Here's how the deal worked: the Fed agreed to loan $85 billion to AIG at a very high interest rate. That's what the Fed gets out of the deal: enormous interest payments. But the Fed told AIG that it couldn't have the loan unless it made the US Treasury (the taxpayers) the majority shareholder in the company. So now, the Fed (as AIG's biggest creditor) and the US Treasury (as the majority shareholder) control the direction of the company.
The first thing Bernanke and Paulson did was fire the old CEO and hire a new one. The next thing they're going to do is sell off AIG's valuable assets and use the money to pay off creditors (including that huge $85 billion loan to the Fed). If there's not enough money to pay all the creditors, the US Treasury (taxpayers) will be on the hook to cover the bill. And all the junk assets that couldn't be sold will belong to the US Treasury (taxpayers), including AIG's credit default swaps. Don't be fooled by statements that claim the US Treasury (taxpayers) could make some money off this deal. There's no market in credit default swaps, so there's no place to sell this junk, and there never will be. It's worthless.
So, if they'd been allowed to fail and declare bankruptcy, AIG would have had to sell off all its assets and pay as many of its creditors as it could. Everyone else, including its bondholders, shareholders, and customers who owned credit default swaps, would get nothing. Under the bailout plan, the US Treasury will ensure that at least the bondholders and customers of AIG get something--all at taxpayers' expense.
Q: What about the bigger bailout that Congress is considering? Isn't that just going to help the rich jerks who got us into this mess? Why doesn't Congress do something to help people like you and me who are losing their homes to foreclosure?
A: You're right, there are two ways to handle the problem. You can inject money into the top of the pyramid and bail out the big banks and investors, which is what's happening now. Or you can spread money around at the base of the pyramid by helping out folks going through foreclosures. But the time to do that is past. Back in late 2007, housing advocates called loudly for a government plan to help people refinance their mortgages; this would have forced banks to take write-downs for part of the value of the bad loans they made. Sure, there would have been turmoil at the top, but it wouldn't have been as bad as it is now. For one thing, everyone would have had a better idea of how big the problem is, instead of continually trying to guess, and then finding out you're still underestimating the problem.
Even back in March,
when Bear Stearns collapsed, there was an opportunity for the
Bush administration to wake up and formulate an overall plan for
addressing the problem. There was still time for President Bush
and Treasury Secretary Henry Paulson to put together legislation
that might have helped homeowners and given Wall Street some guidance
on how to get through this crisis. But at every step of the way,
the Bush administration was hamstrung by its own extreme free-market
ideology, which prohibits
government from interfering with the "self-correcting" market. The current panic is the result of that inaction.
Q: I'm not surprised that George Bush didn't have a plan; that's his modus operandi, whether we're talking about stuff here at home or the war in Iraq. But what about the presidential candidates? Do they have any plans to deal with this crisis?
A: John McCain has done a number of flip-flops when it comes to the economy. He has a record of supporting deregulation, and his senior advisor on the economy is Phil Gramm, the man who drafted key legislation to deregulate the finance industry. But just last week McCain started talking about imposing more regulation on banks and finance companies. He's also done a complete U-turn on bailouts. He was against bailing out any private companies, but last week he changed his mind and supported the bailout of AIG. Then he changed his mind yet again and scolded the Fed for setting up a bailout plan for the industry and said it should stick to managing inflation and ensuring a strong dollar. That made people question whether McCain is on the same planet as the rest of us. It doesn't help that the only concrete proposal he's made so far is to set up a commission to study the financial crisis.
Obama, on the
other hand, has been clear and specific about what he would do.
Back in March, when Bear Stearns collapsed, Obama listed three
things that should be done immediately: 1) the Fed should be allowed
to regulate any company that borrows money from it, 2) regulators
should set standards for how much cash on hand each bank must
have, ensuring that banks have
adequate cash-flow (liquidity) and not just adequate capitalization (which measures assets that aren't necessarily easy to sell), and 3) the federal government should create an oversight body that can identify risky types of investments before they become a threat to the stability of the system (in other words, regulate derivatives and ban the riskiest ones before they are widely marketed and sold). These three very specific proposals show that Obama at least understands the nature of the problem. Obama wouldn't necessarily do a better job managing the economy than McCain would, or even do things differently from McCain. But at least Obama isn't stumbling in the dark trying to figure out the problem. He know what it is, and that's the first crucial step in finding a solution.